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IRS INTENTIONALLY DEFECTIVE IRREVOCABLE GRANTOR TRUST S CORPORATION AUDIT

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If you are still an S Corporation and for whatever reason have not converted to an Limited Liability Company, and are getting ready to hand your business over to the next generation still operating as an S Corporation, why not consider transferring S Corporation ownership of your various family members to an Intentionally Defective Irrevocable Grantor Trust.  Having an Intentionally Defective Irrevocable Grantor Trust own S Corporation shares will not only allow an easy direct succession to your heirs but will also protect your children and grandchildren from unexpected divorce, bankruptcy and creditor law suits and at the same time allow for the Trust to pay the taxes each year on behalf of the beneficiaries without incurring Gift tax.  Too good to be true?   While this strategy is indeed tried and true, the danger remains as the IRS waits until you die, very patiently I might add, to audit not only your estate, but to try as hard as they can to disallow your S Corporation election based on an expected Government claim that the required grantor trust status to hold the S Corporation stock was not adequately achieved.  As a result if you lose in US Tax Court you could owe huge back taxes and may have to sell the business to pay the tax. So if you are interested in handing down your family business to the next generation in a safe protected structure that will last for generations while at the same time saving annual gift and income tax each year, stay with us here on TaxView with Chris Moss CPA Tax Attorney to learn how best to protect your family business S Corporation from the IRS S Corporation Intentionally Defective Grantor Trust Audit.

IRS Code Section 671-679 says if you transfer assets to a trust you control, by definition, a revocable trust, you are in fact the Grantor, and income and expense of the trust are taxed to you personally.  But unfortunately if you were to fund your revocable grantor trust with S Corporation shares and related corporate dividend distributions from a family business, your ownership of these S Corporation shares would still remain inside and part of your estate.  Thus upon your passing your S Corporation would be taxed in 2017 on any value over your $5.49M ($10.98 Married) lifetime exclusion.

Alternatively, if you give away your S Corporation shares through an irrevocable trust, you successfully have transferred your assets out of your estate for estate tax purposes, but unfortunately Section 1361 says you lose the S Corporation election because you don’t own the stock anymore.  While you can gift your S Shares through a qualified subchapter S trust (QSST) or elect a small business trust (ESBT) each of those trusts are subject to a complex set of IRS rules and regulations that require in my view too much attention to make them worthwhile for most small business S Corporation taxpayers.

But no worry because there is a simple way to both transfer your s corporation shares out of your estate, and at the same time keep the S Election through an intentionally defective irrevocable grantor trust, allowing the triple benefit of the irrevocable trust “effective” for keeping the assets out of your estate but “defective” for income tax purposes thereby defaulting back to a revocable trust allowing for the S Election to be protected and finally being able to pay the taxes each year on the S Corporation profits attributable to the beneficiaries without incurring gift tax.

How is this possible?  It starts with IRS Section 2036, which requires any gifts be brought back to you estate after your death to the extent which you retained a right of possession or enjoyment of, or the right to the income from the property gifted or the right to determine who that person should be to enjoy the property you gifted and the related income thereon.

There is, however, a few IRS sanctioned powers that the IRS says gives you the settlor or grantor irrevocable out of your estate upon death protection, yet at the same time allows S Corporation stock to be owned in the IRS approved Grantor Trust, and the same time the power to of the Grantor to pay taxes each year on the income generated by assets owned by the beneficiaries.  A simple power for the Grantor to be able to substitute assets has been approved by the IRS under Revenue Ruling 2008-22.

The facts in Ruling 2008-22 are simple.  Taxpayer funded an irrevocable trust for benefit of children. The Trustee has the power to acquire any property held by the trust and substitute other property of equivalent value.  Citing Estate of Jordahl v Commissioner 65 T.C. 92 (1975) the IRS holds that substitution power was not a power to alter, amend or revoke the trust within the meaning of Section 2038 (a)(1) and 26 CRF 20.2038-1.

The facts in Jordahl were as follows:  Jordahl, the decedent donor, created a trust for his wife with a provision that allowed for the substituting of insurance policies and securities or other property.  The IRS said that this power of substitution required all the assets held by the trust to be taxed as part of the taxpayer’s estate under Section 2038 (a)(2).  Judge Tietjens of the US Tax Court disagreed saying “we think although the decedent, under his broad discretionary powers with respect to investments, might invest in properties producing either a high or low return, such powers would have to be exercised in good faith in accordance with his fiduciary responsibility and could not be used for the purpose of attempting to favor any beneficiary to the detriment of other beneficiaries. . In other words, a power to replace trust assets with assets of equivalent value simply requires the Trustee to make sure that such a replacement of assets is in the best interest of all the beneficiaries.

Coupling the power to substitute property with a power to pay taxes almost appears “too good to be true” but is in fact true because IRS Revenue Ruling 2004-64 (July 6, 2004) allows the Grantor to pay income tax each year without having to report gift taxes to the beneficiaries on the tax paid.  The facts in the case are simple:  Taxpayer created an irrevocable trust for benefit of the children and retains no beneficial interest or power over the Trust income or principal that would cause the assets to be included in the Taxpayer’s estate.  The Trust further allowed but did not require the independent trustee to reimburse the beneficiaries for any income tax liability they incurred on trust income attributable to the beneficiaries’.  The Question presented to the IRS was whether a trustee discretionary decision to pay the taxes constituted a taxable gift to the beneficiaries.

The IRS concludes that the Taxpayer’s discretionary payment of taxes on the Trust income attributable to the beneficiaries is not a gift because the taxpayer not the Trust is liable for the taxes citing a 1944 case Commissioner v Estate of Douglas 143 F.2d 961 (3rd Cir 1944).  As the Douglas case makes clear the trustee must he independent and have discretionary not mandatory power to pay the taxes.  Taxpayer wins, IRS loses.

What does all this mean for Estate Planning with S Corporation stock?  By all means after consulting with your tax attorney transfer the S Corporation shares to an Intentionally Defective Grantor Trust for all owners with key discretionary substitution provisions to allow for Grantor Status and discretionary power to pay annual income taxes.  You will be not only creating a solid Estate Plan, but saving annual gift tax on the taxes the Trust pays while saving annual income tax to the beneficiaries.   Rest assured with good advice from your tax attorney your tax strategy will win big when the IRS intentionally defective Grantor Trust audit comes knocking on your door years after you have long passed.  Thank you for joining Chris Moss CPA Tax Attorney on TaxView.

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Kindest regards
Chris Moss CPA Tax Attorney

About the author

Chris Moss CPA

CPA (SC DC VA CA); ATTORNEY (DC VA); BA, MS Accounting, JD (Georgetown University) Leukemia Ball Founder...Member American Institute of CPAs, Virginia State Bar, American Bar Association, South Carolina Association of CPAs, District of Columbia Bar, United States TAX COURT;.United States SUPREME COURT; IRS Appeals United States Court of Appeals for the 4th Circuit, US Tax Court Appeals, Virginia Supreme Court,.IRS Audit Representation; Entertainment law Tax Planning and Strategy, MDDC Medical Multi-discipline practice tax structure, Bullet Proof Tax Preparation, International and off shore Tax Law, Divorce Tax Law Forensic Analysis, Real Estate tax law including tax strategy for Real Estate Professionals, Annual personal Income Tax Tune Up, Annual business structure analysis, Family Limited Partnerships and gift tax returns and strategy. South Carolina office for H Christopher Moss, CPA, 210 Wingo Way, Suite 303, Mount Pleasant SC 29464..Virginia office for Infinite Partnerships, H Christopher Moss, Attorney, 211 N Union St, Suite 100 Alexandria, Va. 22314